UBS Bonus Plan Gives Bankers Incentives to Take Less Risk

UBS AG (UBSN)’s plan to pay part of top employees’ bonuses in bonds that can be wiped out will give traders and bankers an unfamiliar incentive: limit risk.

UBS will compensate some workers with contingent capital bonds, which can be written off if the bank’s common equity ratio falls below 7 percent or the company needs a bailout, the Zurich-based firm said yesterday.

The shift satisfies calls by regulators for debt-based pay and helps UBS meet stricter capital requirements, while risking defections among top performers. It may also go beyond pay changes at other companies in tying employees’ rewards to the bank’s safety as UBS exits some businesses and tries to move beyond recent trading losses and low returns.

“It’s hard for people to step out of their worlds and think macro about these institutions,” said Sallie Krawcheck, a former Bank of America Corp. executive who called for bankers to be paid with debt in a Harvard Business Review article last year. “While a trader, an investment banker or a financial adviser might not think about UBS’s leverage ratio, they will think about the message they get from this about the risk tolerance of the company.”

About 500 million francs ($551 million) of bonuses will be paid in contingent capital bonds, which vest after five years. The securities will account for 40 percent of bonuses for executive board members and 30 percent for all other employees with total compensation of more than $250,000.

‘Paradigm Shift’

“This is a significant move by UBS,” said John Purcell, chief executive officer of Purcell & Co., a London executive-search firm. “They have moved further than the other institutions in deferring compensation. This could be the start of an overall paradigm shift or signal a separation of banks into haves and have-nots.”

Morgan Stanley plans to defer all bonuses for the best-paid bankers and traders, a person briefed on the matter said last month. Deutsche Bank AG shifted to five-year vesting for stock awards, and Credit Suisse Group AG plans to pay some awards tied to a portfolio of structured products and cash bonuses that can be clawed back over three years.

Barclays Plc deferred part of its 2010 bonus pool for senior employees over three years under a plan that pays only if the core Tier 1 ratio, a measure of financial strength, is at least 7 percent.

Other banks’ changes to compensation and cuts to headcount and pay across the industry may limit defections caused by UBS’s move, said Jason Kennedy, chief executive officer of Kennedy Group, a London-based recruiting firm. UBS notified about 1,900 employees that their jobs would be cut in the fourth quarter, Chief Financial Officer Tom Naratil said yesterday.

Stampede Impetus

“In normal circumstances, the message from management will cause a stampede out of the firm,” Kennedy said. “In these lean and scarce times, the good traders will go to hedge funds but the rest will stay and morale will be even lower than usual.”

UBS cut its bonus pool, including pay deferred into future years, by 7 percent to 2.5 billion Swiss francs. The firm said last year it would exit some fixed-income businesses, and the reductions and bond-based awards show how difficult it would have been for UBS to have stayed, said Ilana Weinstein, chief executive officer of New York-based search firm IDW Group LLC.

“They are an example of a European bank that won’t be able to compete in all of these balance-sheet-intensive businesses,” Weinstein said. “This year, differentiation in compensation will come between the big-balance-sheet American banks who can compete and Europeans who can’t.”

Shrinking Business

The structure of the UBS awards may help dispel opposition to shrinking trading operations, said Nuno Fernandes, a professor of finance at IMD Business School in Lausanne, Switzerland. UBS said yesterday that it cut risk-weighted assets by 32 percent in 2012, helping to boost the Basel 3 common equity ratio to 9.8 percent, higher than the six largest U.S. banks and almost 3 percentage points above the bonds’ trigger.

“Since the bonds’ value relies on the core capital ratio not decreasing below 7 percent, and the IB is the key consumer of capital, reductions in the size of the investment-banking arm, according to the recent UBS strategy, will also guarantee the value of the bonds,” Fernandes said. “We thus have alignment of objectives.”

Bail-In Bonds

Senior bankers should be required to receive some annual bonuses in bonds that would suffer losses during a financial crisis, the European Banking Authority said in December. A “mandatory share” of bonuses for top management should be paid in so-called bail-in bonds, which can be written down when capital dips below a safe level, the regulator said in an opinion on proposals to separate banks’ commercial and investment units.

“A bond has a fixed upside -- they don’t get paid any more for taking big risks,” said Frederick Tung, a law professor at Boston University who called for bankers to be paid in debt instruments in a 2011 paper. “If you substitute bond compensation for stock compensation, you essentially steer their incentives toward more conservative strategies.”

Almost 37 percent of shareholders voted against UBS’s compensation report for 2011 at the annual meeting in Zurich on May 3. Chairman Axel Weber pledged at the time to “very seriously” consider compensation issues. The bank had in-depth discussions with its biggest shareholders to better understand their views on pay, UBS said yesterday.

The new plan is “designed to attract and retain employees who share the same vision that we do for the bank, which is for us to deliver sustainable returns and also to run our businesses responsibly with an eye to the operational risk control,” Naratil said in an interview. “We think it aligns things properly.”